Pimco Ups the Ante in Fixed Income

This commentary originally appeared on Feb. 7 on ETF Profits -- to access all the strategies from our team of ETF professionals, click here.

Pimco entered the ETF market with indexed fixed-income products in 2009, as fixed-income ETFs were becoming a greater part of the ETF market. I believe that the firm hoped to build a platform to use its esteemed brand name to expand into other distribution channels. Traditionally, Pimco's fixed-income products were mutual funds with a variety of fee classes sold through financial intermediaries who earned part of the fees. In entering the ETF market, the firm initially offered very low-cost index-based products with expense ratios even lower than Vanguard. Pimco was then the first ETF provider to offer actively managed ETFs investing in U.S. money markets and municipal bonds.

Recently, Pimco also was a first firm to offer bond ETFs investing in investment-grade debt in single foreign countries, including those investing in Australia, Canada and Germany. I believe the Pimco Germany Bond Index Fund (BUND) offers an attractive play for those who think the European debt crisis will be resolved, leading to improvement in price for German bonds. It also offers a play on an improving euro.

Pimco's two most successful ETFs, the Pimco Enhanced Short Maturity Strategy Fund (MINT) and the Pimco 1-5 Year U.S. TIPS Index Fund (STPZ) have raised $1.8 billion and $1.0 billion, respectively. They are two of my favored ETFs in my fixed-income asset-allocation model. For a cash equivalent, I favor MINT, which is an actively managed ETF that invests in short-term securities. These securities actually have more risk than cash, but I believe Pimco can add value when short-term rates finally increase. I favor STPZ for inflation protection, since compared to other ETFs based on a broad Treasury inflation protected securities (TIPS) index, a short-maturity TIPS index has less interest-rate risk and lower volatility.

Pimco recently upped its commitment to ETFs, as the firm announced that it will bring out an ETF version of its Total Return Fund on March 1, 2012. The Pimco Total Return Fund (PTTAX) is the world largest mutual fund and holds over $240 billion in assets spread across various share classes. The vaunted fund, which is overseen by bond guru Bill Gross, will celebrate its twenty-fifth anniversary later this year. Even with some missteps in 2011in terms of lightening up on Treasury bond and interest rate exposure too early, the Total Return Fund has handily beaten its benchmark and most peers over longer time periods.

I believe that the Total Return Fund as an ETF will have broad appeal to investors who want an actively managed ETF portfolio as a key part of their core fixed-income holdings, particularly in tax-deferred accounts such as IRAs. The ETF will offer many advantages, including lower fees and intraday trading, and should be the most successful ETF launch in many years. The ETF will have an expense ratio of 55 basis points compared to the 90 basis points charged by its open-end fund counterpart. But there will be some differences between the two, one of which is that the ETF version won't use options, swaps or futures. That could change if the SEC lifts its current ban against new ETFs trading in derivatives.

I believe that Pimco held off on introducing its crown jewel into the ETF market until the firm established itself in the space and until actively managed ETFs became more accepted. Fixed-income ETFs have been the fastest-growing part of the ETF market over the past few years, however, taking in $47 billion of $115 billion in new cash flows in 2011. Other analysts believe that the cloning of total return likely has to do with financial advisers who are increasingly turning to lower-cost ETFs to build client portfolios.

Bill Gross is hoping the Pimco Total Return ETF can someday grow to become the world's largest ETF by assets. Actively managed ETFs haven't been a big hit so far, but Gross obviously brings a sterling reputation and an enviable track record to active ETFs. Speaking at the recent 2012 ETF Virtual Summit, Gross said that an ETF wrapper for the Total Return Fund is something he's wanted to see happen. ETFs have advantages and allow small investors to easily access Pimco strategies, he said.

The Total Return Fund is the world's largest mutual fund and Gross expects the same for the ETF. However, he has a long way to go. The SPDR S&P 500 ETF Trust (SPY) is currently the largest ETF, with assets approaching $100 million. In addition, the five largest fixed-income ETFs offered by iShares and Vanguard have between $10 billion and $20 billion each in assets. Gross may be overstating the short-term potential for the product, but Pimco is in it for the long haul. Still, I do believe that the new ETF will have broad appeal and will be the most successful ETF product launch in 2012.